• ESPPs offer employees a beneficial opportunity to buy company stock at a discount, often with the added benefit of a look-back provision, which can enhance the discount even further.
• ESPPs are accessible to a broad range of employees, not just executives, making them an inclusive benefit that allows employees to participate in the company’s successes and challenges.

Employee Stock Purchase Plans (ESPPs) are a popular employee benefit allowing employees to conveniently purchase company stock at a discounted price through payroll deduction. These plans not only make investing in company stock more accessible, but they also provide a structured way to participate in company growth with built-in advantages – mainly, the possibility of buying shares at a discount.

Unlike Restricted Stock Units (RSUs), Non-Qualified Stock Options (NQSOs), or Incentive Stock Options (ISOs), ESPPs are not awarded to employees. Rather, employees use their own funds to buy company stock at a discount, making it a voluntary investment rather than a direct grant.

Despite this, ESPPs are often grouped with equity compensation because they provide a stock-based incentive. A key advantage is their broad accessibility, allowing employees at all levels—not just executives—to participate in company ownership.

The period during which employees can elect to participate in the ESPP. This typically involves completing a form to elect the deferral percentage of salary. Most companies cap deferrals at a specific percentage of salary such as 10%.

The period during which payroll deductions accumulate. Company stock is not purchased immediately upon deferral. Rather, deferrals accumulate in escrow until the Purchase Date when the collected dollars are used to purchase stock.

The date on which accumulated funds are used to buy company stock.

The date when the employee chooses to sell the purchased shares, turning them from company stock into cash. From here, the employee has several options for allocating the sale proceeds (net of any corresponding tax liability). Considerations include retaining in cash savings, pay down debt, earmark for upcoming expenses, invest for growth, gift to charity, etc.

Commonly confused with Purchase Period, Offering Period represents the overarching time period that can include multiple Purchase Periods. Offering Periods range from 6 months to 27 months. A longer Offering Period paired with a Look-Back Provision is favorable, assuming a rising stock price, due to employees having the ability to purchase stock at a date 12+ months in the past.

Also known as a Section 423 Plan, Qualified ESPPs are very common for large, publicly-traded companies. The key benefit of a Qualified ESPP is there is no taxable event upon purchase, even if there is a purchase price discount. Said differently, there is no taxable event until the actual sale with a Qualified ESPP. One limitation of Qualified ESPPs is annual contribution limits set at “$25,000/year worth of stock” (based on the Offering Date price).

These plans have no favorable tax features, so any purchase price discount is taxable as ordinary income on the Purchase Date. There are no contributions limits with Non-Qualified ESPPs. In our experience, this ESPP type is quite rare.

This occurs when an employee sells shares purchased through a Qualified ESPP after meeting both of the following conditions, which improves tax-efficiency of the sale.

• Shares are held for at least 1 year after the Purchase Date.
• Shares are held for at least 2 years after the Offering Date (1^st day of the Offering Period).

In short, this is anything that does not meet the two-part holding test outlined above in the Qualifying Disposition description. In this case, the full gain is subject to Ordinary Income or Short-Term Capital Gains rates (which are the same).

Now that we’ve covered what ESPPs are, let’s explore how they can be so beneficial. The main value of an ESPP comes from two key features: the discounted purchase price and the look-back provision:

Discounted Purchase Price: Employees can purchase company stock at a discount ranging from 1% to 15%. In our experience, a 10% or 15% discount is most common. This discount provides an immediate gain upon purchase. While this discount provides an immediate advantage, it’s important to remember that the stock price is not guaranteed to remain stable. If the stock price declines after purchase, the discount may not translate into an actual gain. To illustrate how this works, let’s look at an example.

• • Example: Assume a company provides employees with a 10% purchase price discount. If the market value of the stock on the purchase date is $20/share, the employee will be able to purchase stock at $18/share (10% discount). If the employee deferred $9,000 to the ESPP, they will be able to purchase 500 shares of company stock; $9,000 / $18/share. The market value of these 500 shares will be $10,000 upon purchase; 500 shares x $20/share. Thus, the employee has an immediate $1,000 unrealized gain upon purchase. If able to sell the shares right away, they can lock-in this $1,000 gain.

Look-Back Provision: This provision allows employees to purchase stock at a historical price (typically 6 months, 12 months, or 24 months prior), opposed to the Purchase Date price. If the stock price has appreciated since that historical date, the effective purchase price discount can be very substantial.

• • Example: If the current stock price is $10/share, but the ESPP’s Look-Back Provision allows employees to purchase the stock at $7/share (the historical price), that provides an effective and immediate 30% purchase price discount.

Most ESPPs with this Look-Back Provision allow employees to purchase the stock at the lower of the current stock price or the historical price. For example, if the current market price (Purchase Date price) of a stock is $10/share but the historical price is $12/share, employees would prefer to purchase at the lower, current market price of $10/share. Overall, the Look-Back Provision is an employee-friendly feature, allowing employees to purchase stock at the more favorable (lower) price.

The most advantageous ESPPs offer both features above.

For example, consider an employee who participates in an ESPP with a 15% discount and a look-back provision. If the current stock price is $100/share, but the historical price is $80/share, the employee would be able to buy the stock for $68/share. This equates to buying at the favorable historical price, $80/share, but also receiving the 15% discount. In aggregate, the employee would be able to purchase stock at $68/share when the current stock price is $100/share. This represents an effective (and immediate) 32% purchase price discount.

While many investors seek a 5%, 7%, or maybe 10% return on their investments per year, receiving an immediate 10%, 15%, or even higher (such as the 32% illustrated in the example above), is hard to ignore. In light of this, we typically encourage employees with access to an ESPP to participate. Especially when their specific company’s plan offers both features highlighted above.

The tax treatment of ESPPs depends on whether the plan is qualified (Section 423) or non-qualified, and how long the shares are held before selling.

Qualified ESPPs (Section 423 Plans)

• No taxes owed at purchase, even if shares are bought at a discount.
• Taxes apply when shares are sold, depending on whether the sale qualifies as a Qualifying or Disqualifying Disposition:
  • • Qualifying Disposition: If shares are held for at least 1 year after purchase AND 2 years from the start of the Offering Period, the discount may be taxed as ordinary income, while any additional gain is taxed at long-term capital gains rates (lower than ordinary income tax rates).
    • Disqualifying Disposition: Selling before meeting the holding requirements means the discount is taxed as ordinary income, and the rest is taxed at short-term or long-term capital gains rates based on how long the shares were held.

Non-Qualified ESPPs

• The discount is taxed as ordinary income at purchase.
• Any future gain or loss when shares are sold is subject to capital gains tax (short-term or long-term, depending on holding period).

• Overlooking ESPPs Due to Cashflow Constraints: While we understand most people cannot afford to reduce their net income by up to $25,000/year, it is hard to ignore the purchase price discounts. Therefore, at times we will recommend clients knowingly draw down bank assets during the Purchase Period, then replenish bank assets by immediately selling ESPP shares upon purchase.
• Overlooking ESPPs Due to Existing Over-Concentration Risk: Knowing that ESPP deferrals are not used to purchase stock until the actual Purchase Date, and knowing that employees are allowed to sell ESPP shares immediately upon purchase (or shortly after, barring any closed trading window considerations), we’d contend that ESPP participation only increases your company stock exposure for a few trading days. In situations where an employee already has too much company stock exposure, we commonly recommend ESPP participation but with the diligence to immediately sell shares upon purchase.
• Missing Deadlines: Enrollment windows and purchase dates are strictly set. Missing them means waiting months for another chance to participate.